If you are looking for fast cash that uses real estate as collateral, you may have come across hard money loans. Hard money loans are often available for real estate investors looking to flip a house or for consumers who have been denied funding from a traditional loan or mortgage refinance.
Here, you will learn how hard money loans work and how this type of loan compares to other forms of funding, like a Personal loan.
Hard Money Loan Defined
Hard money loans, also called bridge loans, are a type of secured short-term financing that uses real estate property as collateral. When a loan has collateral, this means the borrower has offered an asset to secure their loan funding.
The funding amount for a secured loan is often heavily based on the value of the collateral the borrower offers. Typically, the higher the value of the collateral a borrower uses to secure a loan, the higher the loan amount they will receive. For hard money loans, the funding amount is typically determined by the estimated market value of the property being used as collateral.
Furthermore, hard money lenders are usually non-conforming. A non-conforming loan is essentially a loan not funded or backed by a traditional bank. Loans may be non-conforming if they cater to borrowers with credit scores lower than a bank’s minimum credit criteria or deal in funding amounts that are significantly higher than a traditional bank or lender’s loan limit.
Who Are Hard Money Loans For?
Hard money loans work best for consumers or companies looking to profit from real estate investments. Borrowers may seek funding from a hard money loan for the following reasons:
- To flip a house.
- For purchasing investment property.
- For buying commercial real estate.
What To Expect From Hard Money Lenders
Financial institutions that deal with hard money loans typically specialize in this particular product alone, meaning you probably won’t find hard money loans from your local bank chain. If you want to get a hard money loan, you will most likely have to visit a hard money lender specifically.
Furthermore, since hard money loans are almost always non-conforming, lenders may not be subject to the same rules and regulations that govern most traditional lenders. This means that hard money lenders may establish their own rules regarding eligibility criteria when it comes to credit scores, debt-to-income ratios, or other financial factors of the borrowers they work with.
Once you’ve found a lender that works with hard money loans, you should expect heavy fines and fees if you decide to work with this particular lender. Typically, hard money lenders require a very large down payment at the beginning of the loan period. Furthermore, they will usually charge exceptionally high-interest rates as well.
Pros and Cons of Hard Money Loans
When getting any type of loan, comparing the advantages and disadvantages is essential if you want to make sure your loan will fit in with your current financial situation. After learning about the pros and cons of hard money loans, you can assess how much the advantages will help you out compared to how much the disadvantages could hurt your budget.
Hard Money Loan Pros
Below are some of the perks borrowers may find helpful regarding hard money loans.
Speedy Approval and Less Strict Underwriting
Hard money loans can have significantly faster approval times compared to other types of real-estate secured funding. Traditional mortgages can take weeks or even months to be finalized, while approved borrowers may be able to access cash from hard money loans in a matter of days. This streamlined service can also cause hard money loans to have less underwriting charges, like origination fees.
Approval Based on Collateral Instead of Credit History
Since hard money lenders offer secured loans, they usually care more about the equity in a borrower’s collateral instead of their credit score. So, bad credit borrowers may be able to access high loan amounts via hard money loans if they own property with enough equity.
Ability To Fix and Flip Properties
Home renovations can get expensive, making it difficult for real estate investors to fix up properties and resell them without an alternative source of income. Hard money loans can make it more convenient for people to perform repairs and renovations to civilian or commercial real estate properties and then go on to sell them to individuals or businesses.
Hard Money Loan Cons
Below are possible disadvantages all borrowers should be aware of before they apply for a hard money loan.
High-Interest Rates and Short Repayment Terms
Hard money loans are known for having exceedingly high-interest rates and brief repayment terms. High rates paired with short repayment terms typically result in high loan payments, which may be difficult for some borrowers to keep up with. Furthermore, since hard money loans are secured with real estate, borrowers who miss a certain amount of payments or default on their loans risk having their property repossessed.
Large Down Payments Are Often Required
Hard money loans may also require a down payment based on the loan-to-value (LTV) ratio. A loan-to-value ratio is simply the funding amount of a loan compared to the value of the collateral used to secure the funding. Instead of offering loan amounts based on 100% of the value of a real estate property, lenders may fund loans for approximately 70% to 80% of a property’s equity.
Since the down payment for a hard money loan is usually calculated using the loan’s LTV, loans secured by properties with high equity and therefore yielding high loan amounts will almost always require a correspondingly high down payment. If you cannot afford a large down payment at the beginning of your loan period, you may not be able to qualify for hard money loans.
High Risk
Borrowers who take out hard money loans risk the housing market declining and significantly lowering the value of their real estate. A significant drop in the housing market may cause the value of a borrower’s real estate to decrease to a value that is lower than what they currently owe on their hard money loan. Situations like this result in what is called an upside-down loan.
A loan is usually considered upside down when the collateral used to secure the funding is worth less than the balance due on the loan. An auto loan or a home equity loan are two common types of funding, besides hard money loans, that may become “upside down” if their market value drops drastically.
May Require “Track Record” of Successful Hard Money Loans
While hard money loans are usually considered high risk for the borrower, they may also be considered high risk for the lender as well. Offering high loan amounts to borrowers with a wide variety of credit scores puts lenders in the position of working with consumers who may not have an established history of successfully paying off loans. To counter this risk, some hard money lenders tend to favor borrowers with a track record, or proven history, of successfully paying off hard money loans. This requirement may not pose an issue for a seasoned real estate investor who has made a career of flipping houses. But, for borrowers seeking hard money loans to save their mortgage or for the first time, this requirement may prove to be quite an obstacle.
Alternative Financing Options to a Hard Money Loan
Before contacting hard money lenders, consider the following options that may be able to offer you a better deal:
- Conventional Mortgages: A traditional mortgage may take longer to fund, but there’s a better chance your loan will be backed by a traditional bank, offering you security that hard money loans can’t.
- Home Equity Loan or Home Equity Line of Credit: If you are already the owner of a home or real estate property, you may utilize its value for a home equity loan. Similar to a hard money loan, home equity loans are available even if you have bad credit. However, home equity loans and lines of credit may have more manageable interest rates.
- Personal Loan: A wide variety of personal loans, including personal installment loans, may be a better alternative over a hard money loan. While personal loans are usually unsecured, they may be able to provide borrowers with flexible terms, competitive rates, and loan amounts ranging from a few hundred to a few thousand dollars.
Hard Money Loans vs. Traditional Mortgages
According to the Corporate Finance Institute, consumers could get a 30-year fixed mortgage with a 4% interest rate in 2019. In comparison, the typical hard money loan had rates as high as 8% during this time. While hard money loans and a traditional mortgage can vary greatly regarding interest rates, they are also vastly different regarding approval time and repayment options.
Approval Time
Traditional mortgages tend to have a stringent approval process involving submitting multiple documents, attending in-person meetings, and having an inspector visit your home / real estate property to assess its equity. The approval process alone can take days or even weeks. From there, borrowers may also wait a few weeks or more for funding on their mortgage to go through. So, if you are looking to get cash quickly using your home or real estate property as collateral, you may not find a traditional mortgage helpful.
Hard money loans, on the other hand, can have a combined approval and funding time of just a few days. Borrowers may be able to receive approval the same day they apply and receive their approved funds in less than a week.
Repayment Options
Loan terms may also vary greatly when comparing a hard money loan and a traditional mortgage. A hard money loan may only offer borrowers a few years to pay back the entire balance, while typical terms for a mortgage can range from 15 to 30 years or more.
Hard Money Loans vs. Personal Loans
You may also want to compare hard money loans and personal loans.
Qualification
The most significant difference borrowers and consumers may find between hard money loans and personal loans are the qualification requirements. Since personal loans aren’t always secured, they may rely more on the borrower’s credit score when determining approval. This means that borrowers with a good credit score are more likely to find approval for personal loans than poor credit borrowers.
Comparatively, hard money loans are secured, so lenders for this type of loan usually care more about the value of the collateral instead of the borrower’s creditworthiness.
Interest Rates
Most personal loans also use the borrower’s credit score to determine other loan details, including interest rates, in addition to general loan approval. Just as good credit borrowers are favored when it comes to approval for personal loans, they are also favored when it comes to interest rates as well. Borrowers with high credit scores are more likely to receive lower interest rates compared to bad credit borrowers. Hard money loan rates, on the other hand, are likely to be extremely high regardless of the borrower’s credit history and credit score.
The Bottom Line: Understanding the Risks of Hard Money Loans
While hard money loans can prove to be lucrative when it comes to real estate investing and house flipping, they also come with considerable risks that could be detrimental to your finances if you are not prepared. The most important rule of thumb when partaking in any kind of investment opportunity, whether that be purchasing stocks, bonds, or hard money loans, is to never invest money you aren’t willing to lose.
Before considering non-conforming funding, such as a hard money loan, you should make sure you can’t qualify for more traditional financing first. There is a good chance you will be able to receive a better deal with traditional loans that won’t require you to use real estate as collateral.
References:
Non-Conforming Loan – Definition, Example, How to Choose a Lender
